Weekly Focus :Renewed Pressure on US Housing Market

In the past week the news has once again been dominated by troubles on the financial front. In particular, attention has focused on problems at US mortgage lenders Fannie Mae and Freddie Mac, which currently account for around 75% of all mortgage lending in the US and therefore play a vital role in the country's housing market. These two GSEs have suffered substantial losses on their holdings of mortgage bonds and are under huge pressure to raise new capital. When they came under the spotlight earlier in the summer, the US government was obliged to step in with an explicit guarantee that it would inject money if necessary. The purpose of doing so was to restore confidence in both GSEs so that private investors would put money into them.

However, investor interest still remains very limited, increasing the likelihood that the US government will have to honour its guarantees and inject public money into both GSEs. This has hit their respective share prices hard as such action could dilute the value of existing shareholders' investments.

This situation is particularly crucial for the US economy because it could exacerbate the housing market situation. If the ability of both GSEs to buy mortgage bonds is restricted by a shortage of capital, this would further decrease the availability of mortgage financing, even for good payers. This would in turn dilute the effect of the Federal Reserve's substantial easing of monetary policy earlier this year, and emphasise the problems involved in getting monetary policy to make a difference where it really counts. Latest housing market data also give cause for concern, suggesting a renewed deterioration after a measure of stabilisation had begun to look imminent.

Euroland: Spotlight on Germany with weak Ifo expected

The past week has seen the release of PMI data for Euroland, Germany and France. While the PMI for Euroland as a whole was practically unchanged from July, the French PMI and especially the German PMI fell, which means that there has been a much needed improvement in the very weak PMIs for Spain and Italy (data for these countries have yet to be released). Otherwise the most notable thing about the PMIs is that they suggest that inflationary pressure is receding, and that Euroland is teetering on the brink of recession.

As expected, the PMI for the German manufacturing sector dropped below 50, which indicates contraction, and we believe that the drop in the PMI marks a fresh period of decline. We will see this reflected in the coming week's Ifo index, which we expect to fall from 97.5 to 96.5. We also expect the index for the current business climate to drop from 97.5 to 96.5, and the expectations index from 90 to 89.5. In all three cases, our forecast is below the level generally predicted by other analysts. In other words, our view of the German economy is more pessimistic than the consensus.

The coming week also brings detailed Q2 national accounts figures for Germany which will tell us more about how much of the high level of activity in Q1 was down to temporary factors (such as good winter weather for construction and stockbuilding) that reversed in Q2. We will also get August inflation figures for Germany and Euroland. We expect inflation in Euroland to hold at 4.0% in August and then begin to fall.

Key events of the week ahead

• Tuesday: We expect the detailed Q2 national accounts data for Germany to confirm the flash estimate for GDP growth of -0.5% q/q. We also predict weak Ifo data, with the main index and the current climate index both falling from 97.5 to 96.5 and the expectations index from 90 to 89.5.
• Friday: We expect Euroland HICP inflation to hold at 4.0%.
• The week will also bring German inflation figures for August. We forecast HICP inflation of 3.5% y/y.

Switzerland: Weak outlook for private consumption

The latest figures from the Swiss economy seem to confirm the picture of a slowdown in private consumption. On 14 August consumer confidence slipped to its lowest level since Q1 2004, and the past week has brought figures for retail sales in June, which grew by just 0.7% y/y despite EURO 2008, down from 7.4% in May. That said, the retail sales series is highly volatile, and if we allow for the number of trading days, retail sales grew by 4.7% y/y. There is no definitive answer as to which method is best for measuring retail sales, but clearly the two methods lead to very different conclusions about Swiss private consumption.

Foreign trade statistics for July were released on Thursday. Switzerland still has a healthy trade surplus, currently CHF 2.4bn. If we drill a little deeper, exports grew by 0.8% m/m, while imports grew by 0.4% m/m. This adds weight to the impression that private consumption in Switzerland is running out of steam, while exports have been propped up partly by demand for Swiss luxury goods in emerging markets. Producer and import prices for July were also released on Thursday. Prices climbed 4.9% y/y, with oil products again contributing to the increase.

Swiss National Bank governor Jean-Pierre Roth has returned from his summer holidays. In an interview in the Financial Times, he says that the economy has slowed more quickly than the bank expected. When it comes to inflation, he seems relatively relaxed: there has been a downward correction in oil prices, the SNB expects the second-round effects to be “acceptable” (due partly to flexible wage formation), and Roth expects inflation to peak in August.

The market has reacted to these comments from Roth, which were seen as dovish, and the OIS curve now shows 10bp lower yields priced in at 12M. In other words, the market now considers it likely that interest rates will come down, whereas only a week ago a 25bp rate increase was priced into the curve.

Key events of the week ahead

• Thursday brings the employment report for Q2.
• Friday sees the publication of the KOF leading indicator. Last time the index was dragged down primarily by a weak outlook for private consumption.

UK: Minutes highlight the dilemma of weak growth and high inflation

The past week didn't reveal much new in the general picture of a rapidly weakening British economy. Retail sales rebounded a bit, rising 0.8% in July, but this was after a drop of 4.3% in June. GDP for Q2 came out weaker than expected at 0.0% q/q after rising only 0.2% in Q2. Hence the overall economy has more or less stagnated in the first half of 2008. Exports and investments were very weak and private consumption fell slightly. Private consumption is likely to soften a lot more in H2, as signalled for example, by the distributive trades survey which is at an all time low (started in 1985). The housing market is also in the doldrums as witnessed by the house price index from Rightmove, which fell 2.3% m/m in August. Overall the picture in the UK is gloomy, and the Bank of England (BoE) is very much aware of that.

The minutes from the meeting of 7 August showed again a split in the BoE which voted 7-1-1 for keeping base rate unchanged at 5%. Tim Besley voted for a 25bp hike, David Blanchflower preferred a 25bp cut while the rest voted for unchanged rates. The split reflects the dilemma of high inflation and very weak growth. Inflation is currently running at 4.4% and heading for 5% in coming months - way above the target of 2%. BoE' went through all the options of raising the Bank Rate, cutting it and keeping it unchanged. A rate hike was would send a strong signal to wage and price setters which would reduce wage pressures and this way constrain the rise in unemployment. The case for a cut is clear with the ailing economy, but the main risk associated with an immediate cut was that “it could cause wage and price setters to conclude that the Committee was more concerned about sustaining output growth than about returning inflation to the target” The third option - unchanged rates - balances the risks from lower growth and higher inflation.

The dilemma for BoE is clear and we think they will be sidelined until inflation gets into a territory where they can cut rates without spurring doubts over their commitment to price stability. This will likely happen in February next year when we expect the first cut in a cycle that should take the Bank Rate to 4% by the end of 2009 (currently 5%). The market currently expects rate cuts of around 60bp next year.

Key events of the week ahead

• Tuesday: BBA loans for house purchase.
• Thursday: CBI distributives trade survey. It is at very weak levels and should be broadly unchanged
• During the week Nationwide house prices for August. Prices are likely to have fallen further. The price declines over the last 3 months have been around 2%. m/m

USA: Just how divided is the FOMC?

The divide in the Federal Open Markets Committee (FOMC) seems to have closed up somewhat in recent weeks, due probably to the drop in commodity prices helping to reassure the hawks on the committee. At the latest meeting on 5 August, only one member (Dallas Fed president Richard Fisher) voted for a rate increase, although it was feared that others would follow suit (see Flash Comment - FOMC: Firmly on hold). The most inveterate hawks on the FOMC have softened their rhetoric slightly in recent weeks and are no longer talking about the need for an immediate rate increase, settling instead for a warning that a hike could come sooner than the market expects. The minutes of the FOMC meeting on 5 August will be released on Tuesday night, and it will be interesting to see how much disagreement there was between the hawks and the doves on the committee.

Before then we will gain an insight into what the Fed believes to be the most important topics in the US economy right now, as this weekend brings the Fed's annual symposium at Jackson Hole. Ben Bernanke will talk about financial stability on Friday afternoon, and it will be interesting to see if he touches on the turmoil surrounding the two big mortgage lenders Fanny Mae and Freddie Mac, which flared up again during the week. An article in Barron's focused sharply on the two GSEs' problems in raising sufficient capital to counter the losses they face as a result of the downturn in the US housing market. The renewed turmoil caused the two lenders' share prices to virtually halve in the last week, and the yield on their mortgage bonds has risen further. The drastic drop in share price will make it hard for the two to raise capital through share issues, and the market is speculating about an imminent government takeover of the two institutions (see Flash Comment - US: Confidence in GSEs is fading rapidly).

The coming week also brings data for personal income and spending. Going from July's retail sales figures, the effect of the tax rebates already seems to be petering out. We expect a decrease in personal spending of 0.1% m/m in July, which would make it very difficult to see positive growth in personal spending in Q3 as a whole. It also seems that most of the rebate payments were made before the end of June, so we expect to see a drop in personal income in July.

Key events of the week ahead

• Monday: We expect sales of existing homes to fall 0.3% m/m.
• Tuesday: We expect sales of new homes to fall to 520,000.
• Tuesday: Minutes of the latest FOMC meeting are released.
• Thursday: The revised GDP figures for Q2 are expected to entail an upward revision of growth to 2.5%.
• Friday: We expect drops in personal spending and income in July.

Asia: Speculation about Chinese stimulus package

In the past week there has been speculation in China that the government is set to announce a fiscal policy stimulus package. As we have mentioned before, there is much more scope for stimulating growth now that inflation has come back down and is probably set to continue falling in the coming months (see Flash Comment - China: Inflation drops more than expected in July). At the same time, exports have moved into a slightly lower gear (see Flash Comment - China: Industrial production slows in July). However, we do not expect any major fiscal policy moves from the Chinese government in the short term. Data for July have been better than expected and suggest that the slowdown in economic growth was only modest, thanks to continued relatively robust domestic demand (see Flash Comment - China: Investment accelerates slightly going into Q3). It is therefore too early to completely disregard the inflation risk. As a result, we anticipate a relatively cautious line from the Chinese administration - a line most recently seen when the government chose to raise bank lending quotas at the beginning of August rather than lift them altogether (see Flash Comment - China: No need for more tightening). If there is a need to stimulate growth, the first step will probably be the complete abolition of these quotas. Major fiscal policy easing could be the next Chinese bulwark against weaker international activity, but hardly one that China will be needing in the short term.

In Japan, the past week has brought some relatively good news for a change. Exports grew again in July after falling sharply in Q2 (see Flash Comment - Japan: Exports recover in July), which suggests that exports are not in freefall in Q3 after all, and that net exports will again make a slight positive contribution to GDP growth. The downside risk to our GDP growth forecast of 0.2% q/q in Q3 therefore seems to have eased somewhat. The coming week is a busy one for economic data in Japan. We expect inflation to climb above 2% in July, so moving outside the Bank of Japan's official price stability definition of 0-2%. In connection with the week's monetary policy meeting, though, the BoJ signalled clearly that this is not a major cause for concern at present (see Flash Comment - Japan: Rates unchanged, slightly softer view). It will therefore be growth that is the key to the direction and timing of the bank's next move. We still expect it to leave its key rate unchanged over the next year.

Key events of the week ahead

• Friday brings figures for consumer prices, unemployment and industrial production in Japan.
• No important economic data are due out in China during the week.
• Monetary policy meetings are scheduled in Malaysia on Monday, Thailand on Wednesday and the Philippines on Thursday. We predict 25bp rate increases in Thailand and the Philippines but no change in Malaysia.

Foreign exchange: Bullish on JPY, bearish on GBP

Our latest FX forecast update takes a more positive view on the USD than before (see: On the brink of a global recession), due mainly, as we discussed in last week's Weekly Focus (see: EUR/USD turnaround could be slow and bumpy) to a more pessimistic assessment of the economic outlook for non-US markets, and our belief that the year-old financial crisis will continue to impact negatively on risk-seeking in FX markets. We therefore expect the USD to rally against the vast majority of currencies in coming months.

JPY is the only major currency we expect to outperform the USD in the next three months. The JPY is generally undervalued (by 10% vs. USD and 40% vs. EUR), normally copes well during a global economic downturn, and typically strengthens when volatility increases and speculative positions are wound down. Most financial indicators also suggest upside potential in the short term. The latest movements in both bond and equity markets thus suggest that the JPY should be stronger than it actually is. Our short-term model for USD/JPY indicates a neutral level of 106, compared with a spot rate of 108.8.

We expect GBP to perform worst in coming months. We have taken a negative view of the GBP for the past year, initially in response to the financial crisis, then subsequently due to the economic downturn in the UK. The Bank of England is under pressure from weaker economic growth on the one hand and a surprisingly sharp upswing in inflation on the other. We expect the BOE to make room for substantial rate cuts once inflation begins to fall back, but we will probably have to wait until early 2009 for this to happen. We predict that interest rates will be cut by 1pp to 4% in 2009. The GBP will probably remain under pressure in coming months, but more against the USD than against other European currencies. Given the current sharp economic slowdown in Euroland, we have cut our 3m EUR/GBP forecast from 0.82 to 0.81. Against the USD, we expect the GBP to fall to 1.77 from a spot rate of 1.86.

We take a moderately negative view of the SEK over the next couple of months. The Riksbank may still raise interest rates at its meeting on 3 September, although in view of the expected economic downturn, the real question is how many rate cuts we can expect in 2009. As in 2001, there may well be a very short gap between the final rate hike and the first rate cut, implying that the SEK could be unable to draw much strength from any rate increase. With movements in equity markets and changes in risk appetite the main drivers behind the SEK recently, without an improvement in both it seems probable that the SEK will weaken moderately over the coming months. Our 3m EUR/SEK forecast is 9.45, up from 9.38 today.

Our view of the CHF is unchanged - we expect the currency to appreciate moderately against the EUR over the next 3m, bringing the EUR/CHF down from 1.618 to 1.60.

Fixed Income: Rise in oil price puts inflation back on the agenda

Bond markets continue to trade on three broad themes - recession fears, financial crisis and inflation. Ebbs and flows in the news flow on these three factors explain most of the moves in the bond market currently. Over the last two months the market changed its focus rapidly from high inflation to recession fears. The reason was clear: growth figures dropped dramatically in Germany while commodity prices fell back, easing the inflation concerns. Now the market is to a greater extent pricing in economic weakness: for example, in Euroland rate cuts of approximately 50bp from ECB during next year are priced in.

Market activity this week suggested it may be hard to push yields much lower in the short term without significant renewed negative growth surprises. Despite financial turbulence the beginning of the week and a fairly weak German Flash PMI yesterday, bond yields quickly recovered after falling. A first sign that it may be hard to go much lower yield wise in the short term. At the same time, inflation fear is creeping back into the market after oil prices rose strongly on Thursday on the back of renewed geo-political tensions between the US and Russia. We believe the oil price could rise further (see Commodities) and hence provide more upward pressure on bond yields in the short term. Investors who are long bonds may use it a reason to cash in as the volatility this year means profits can come and go very quickly. More profit taking on long positions would add to upward pressure on bond yields. Overall, we think the market is in a consolidation phase after the recent bullish run in bonds.

This is purely a short term view, though. Ultimately we still expect bond yields to end the year lower as the risk of global recession will continue to be a big underlying theme. Growth numbers should weaken further globally in the coming quarters, and unemployment should rise in most countries. The tensions in the US mortgage system are adding to downward pressure on the housing market, and in Euroland the lack of any real tailwinds and slowing employment growth pose downside risks to 2009 growth. Hence the pressure for ECB rate cuts will only increase as we move closer to year end.

Next week the market has a lot of US data to chew on. Housing data will be interesting given the latest turmoil in the mortgage market (see front page). Home sales (both new and existing) and house prices (both Case/Shiller and OFHEO) are scheduled for release during the week. In Euroland, Flash CPI and consumer confidence (includes inflation expectations) will be of interest. Otherwise oil price developments will be key.

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